The information content of options

The objective of this thesis is to examine the information content of stock options in financial markets. A key question in financial economics is how information diffuses across markets and how quickly it is reflected in security prices. This thesis aims at exploring this question by investigating the informational role that options play in financial markets. This is achieved by exploring the joint cross section of option and bond prices, the informational role of options in seasoned equity offerings (SEOs), and the information content of options trading prior to announcements of changes to the S&P 500 Index. The thesis comprises three essays, each exploring the information content of equity options trading from a different angle. The first essay examines the joint cross section of option implied volatility and corporate bond returns. Theoretical and empirical work in finance suggests that stocks and bonds of the same issuing firm should share common risk factors. Therefore, new information about a firm should affect both its stock and bond prices. However, if one market offers trading incentives over other markets, informed traders and traders with better ability to process information may choose to trade in that market over the others. As a result, markets that provide advantages to informed traders will incorporate information prior to other markets. The empirical analysis in this chapter reveals that options trading is strongly predictive of corporate bond returns. A strategy of buying (selling) the portfolio with the lowest (highest) changes in option implied volatility yields an average monthly excess bond return of 1.03%. This strategy is statistically highly significant and economically very meaningful and indicates that information is incorporated into option prices prior to bond prices. In contrast, I find no evidence that bond prices incorporate information prior to option or stock prices. Since bond investors are generally sophisticated institutional investors who process information efficiently and the predictive ability of options is persistent, I conclude that informed trading rather than superior information processing abilities is responsible for the predictive ability of options. The second essay explores the information content of option implied volatility around the announcements and issue dates of SEOs. The literature on SEOs indicates that announcements and issue dates contain important information about firms and therefore provide profitable opportunities for traders with private information. While prior research has focused on the information content of short sales around SEOs, this study focuses on the information content of options which can act as an alternative for short selling. The empirical analysis provides evidence of informed trading in the options market around SEO announcements. Around SEO issue dates, I find that higher demand for put options is significantly related to larger issue discounts which is consistent with the manipulative trading hypothesis. The results in this study indicate that regulators should consider extending the short-sale restrictions of Rule 105 to restrict trading in related securities. Finally, the third essay investigates the information content of options prior to the S&P 500 Index inclusion and exclusion announcements. These announcements are unique events since they are not announced by the firm and, as stated by S&P, they should convey no new information. In addition, the large abnormal returns observed following these announcements make them distinctive ground for testing the informational role of options. Consistent with the notion that informed traders operate in the options market, the empirical results in this essay indicate that there is a significant relationship between options trading preceding index inclusion announcements and abnormal returns following these announcements. In contrast, I find no evidence for a relationship between options trading and abnormal returns following exclusion announcements.